With their 75-day consultation period over the issue coming to an end Oct. 2, Prime Minister Justin Trudeau and Finance Minister Bill Morneau are facing an uphill battle against businesses, the opposition and even some of their own caucus members, to push their proposed tax reforms through.
On July 18, Morneau announced a plan to amend the Income Tax Act in order to close certain loopholes and ensure what the government calls fairness in taxation.
Following a cool reaction, during this consultation period the government has been trying to explain why this is necessary and is the right step, while their opponents are fighting back just as hard to argue that the government is being unjust and unfair.
So, what exactly are the liberals proposing?
According to Francois Brouard, an accounting and taxation professor at Carleton University, the government intends to take measures to target three separate areas: Income sprinkling, limiting passive income, and controlling income through capital gains.
Reform 1: Income sprinkling
Brouard explains this with an analogy: Say there is a man, who has a spouse and two children, and has a small business (a Canadian-Controlled Private Corporation or CCPC). Right now, he can either declare his entire income and pay taxes on his personal tax return, or he can divide his income between the rest of his family members, regardless of whether they do any work for the business. If he divides the income, or ‘sprinkles’ it to the rest of the family, the family will pay less in taxes. The government wishes to “put in place rules avoid this kind of income sprinkling,” Brouard says.
In Canada your income puts you in a certain tax bracket, which determines your rate of taxation. The more you earn the more you are taxed. Also, everyone has a basic personal amount which you can earn without paying tax ($11,635 in 2017), so if this is the income some members are declaring, then they aren’t being taxed at all.
“People are saying that this is attacking a lot of businesses. It’s not,” Brouard says. “If you pay a salary to your children or spouse they should be working in the business.”
Reform 2: Limiting passive income
Brouard then explains there are two kinds of income with businesses: active and passive. Active income is the income you earn in relation to the regular operations of your business. While passive income is income earned on investments, such as interest. You could keep the money in the corporation and invest through the corporation, instead of personally.
Right now, one problem with this is that a lot of times the money is said to be kept aside for the business operations and taxed at a lower rate. But instead of being used for the corporation’s growth, it is just being kept in the corporation to avoid the higher personal income tax rate.
In some cases, money kept in a business would presumably be kept in an interest-bearing bank account or some other sort of savings or investment vehicle, such as guaranteed investment certificates for instance. If these earn interest that interest would be taxable, though at the lower business rate as opposed to the personal rate. Or a business could invest the income. If they invested it in shares in companies they would be subject to two types of taxation:
- If the shares they purchased paid dividends, that’s considered income and the company would be taxed on it. However, the tax system includes dividend tax credits, which can significantly lower the tax burden on dividend income.
- The capital gains tax. If the shares purchased rise in value, capital gains tax will have to be paid on the profit. But capital gains tax is payable to only 50 per cent of the profit; the rest is tax free.
No decision has been made on how to proceed with this aspect yet. Ottawa says it is considering different options.
Reform 3: Controlling income through capital gains
A business owner might also take money from his or her company as dividend payments rather than as salary. Either way, the owner also has the ability to convert either type of payment into capital gains, which, as noted above, are taxed at a much lower rate. This process of converting different kinds of payments into capital gains is sometimes called surplus stripping.
Brouard here used another analogy: let’s say you sell something for $1000 but had gotten it for $200. The capital gain here is $800 but you only pay taxes on $400. Business owners can convert business profits into capital gains and receive it as their income and hence pay less taxes on it, than if they were to get those profits as dividends or salaries. The government would work on ensuring any money earned through capital gains isn’t being done just so a business owner can pay less taxes on the money they earn.
Overall, Brouard approves of the proposed measures.
“Do I think it’s fair? The answer is ‘yes,’” Brouard says. “Especially for the income sprinkling,” adding that the public is being given a “biased view of the reaction.”
“Some calculations the Conservatives are putting forward is that the tax rate will be 72 per cent. It is like comparing apples and oranges. No one pays 72 per cent. Not before. Not after. Not ever.” He also says that “since it’s a complex topic a lot of people don’t understand it” – people are just looking for a system which will help them pay less taxes.
The complexity of this topic and the sensitive subject of tax hikes has led to a wide range of reactions across the board. When the government announced their intentions, it was seen as a crackdown on small businesses while leaving the top one per cent to do as they please. The people who got the most coverage were doctors, because the impression is that they will face the most impact.
Two doctors, two opinions
It was confusing to me, what the outrage was about, and so I started to get myself more informed,” says Dr. Rita McCracken, a family physician in Vancouver, who supports the proposed reforms. “I read through the policies, talked to some colleagues, read the commentary, and I just got more and more confused about what the outrage was about.”
“It appeared to me that there were some structures in taxation, which were available to some people with some family structures and with some high levels of income that weren’t available to other people, and that didn’t seem fair to me,” says McCracken.
“I believe in fair taxation. And I believe that people who make more money should pay more taxes.”
Dr. Anita Sanan, an anaesthesiologist at Kelowna General Hospital, has a different take.
“I see a number of flaws with these proposed changes,” she says.
“One is that it’s under the guise of fairness and we actually can’t have a conversation about fairness because we’re not on a level playing field to start with.”
She says that with these changes doctors will face increased difficulties in saving for their retirement and “the government has offered us no alternative to actually save for our pensions if they take away our professional corporations.”
“I don’t know when I’ll be able to retire. It’s basically taking away my future.”
She said that while they could make RSP contributions and open up Tax Free Savings Accounts – and “max them out” – due to the fact that most doctors have a six-figure debt when they graduate medical school and they also have a delayed entry into the workforce because of the many years of schooling, they would never be able to generate enough income through these methods. This is especially if they can’t start contributing until after their debt has been paid off.
“Problem number two is that we’re government employees without any government benefits. If I was to, heaven forbid, get sick, having that passive investment income in my corporation would allow me to draw some money out that is liquid,” Sanan says. This is a trickier aspect since doctors can be seen as government contractors more than employees.
An entire range of viewpoints can be found about this issue, and these potential reforms could be an election issue for the liberals in 2019.
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